James Quackenbush,
The Daily Record Newswire
With the unprecedented decline in the world’s financial markets in 2008 and early 2009 still on investors’ minds, investors should be carefully looking at their investment portfolios, re-evaluating their tolerance for risk and looking for methods to reduce portfolio risk. One important concept for reducing risk is through the means of diversification.
Diversification is the technique of spreading out investments over a large number of securities and asset classes in order to minimize risk. In other words, “don’t put all of your eggs in one basket.” Two primary strategies of diversification are asset allocation and fund objective.
The most critical diversification method is asset allocation. Asset allocation is the strategy of distributing risk among different investment classes such as stocks, bonds and cash. By having your portfolio invested in different asset categories, you can protect your portfolio from losing value.
When a portfolio includes investments in a variety of asset classes, large losses in one asset class could be offset by gains in other asset classes. For example, when stock prices fall, bond prices often rise because investors move their money into what is considered a less risky asset class. A portfolio that included stocks and bonds would perform better than one that includes only stocks at a time when stock prices drop.
Having the proper asset allocation is also very important when constructing a diversified retirement portfolio. The allocation ratio should reflect an individual’s risk tolerance and age. A rule of thumb is to invest your age in bonds. An investor that is 40 years of age should have a portfolio of roughly 60 percent stocks and other alternative investments and 40 percent in bonds.
Furthermore, as an investor gets closer to retirement, they should slowly be reducing their stock market exposure and moving more funds to safer investment such as bonds and money market funds, especially with capital that will be used for living expenses during retirement.
Once an appropriate mix of stocks, bonds and other investment vehicles has been determined, you can further reduce portfolio risk by diversifying the equity portion. This can be achieved by using a combination of different funds with investment objectives in large-cap, mid-cap, small-cap, growth and value stock funds.
An investment portfolio should not contain only large-cap funds. As we’ve seen recently, large Dow Jones component companies that were considered relatively safe, such as General Motors and Citigroup, lost a large percentage of their value or went bankrupt. The “idea of too big to fail” is obsolete.
All companies run the risk of bankruptcy regardless of the company size. Having a portfolio diversified with a variety of different company sizes using small-cap and mid-cap funds along with large-cap funds will help produce a balanced portfolio that minimizes risk.
Additionally, diversifying amongst a mix of growth- and value-oriented funds will further reduce overall portfolio risk. Growth funds consist of companies that tend to have earnings that grow faster than their industry or the overall markets, and are unlikely to pay a dividend. Growth funds will likely outpace the overall market when the economy is healthy and expanding.
Alternatively, value funds will consist of companies that are considered to be good stocks that are undervalued but have strong fundamentals and often pay dividends to their stock holders. Value funds typically do not outpace the markets when the economy is growing.
However, they tend to limit downside risk in a portfolio when the economy is contracting and off-set losses from more aggressive segments of a portfolio. Having a good balance of both growth and value funds will reduce risk and prove beneficial through the full economic cycle.
Diversification is very important for minimizing risk to one’s portfolio. Using an asset allocation strategy of stocks and bonds, along with using a variety of funds with different investment objectives will help produce a portfolio that is diversified and has limited risk in the event one aspect of the portfolio loses significant value. Before making any investment decisions regarding your portfolio, please consult with your investment professional.
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James Quackenbush is an analyst/portfolio manager for Karpus Investment Management, a local independent, registered investment advisor managing assets for individuals, corporations, nonprofits and trustees. Offices are located at 183 Sully’s Trail, Pittsford, N.Y. 14534; phone (585) 586-4680.
